Tuesday, February 14, 2012

The Easiest Way to Increase Investment Returns? Reduce Expenses!

This post highlights the huge impact that just one or two percent in yearly expenses can have on your long-term investment performance. The impact is the same for bonds as it is for stocks.

A previous post discusses expenses that reduce the theoretical, published investment returns -- including taxes, commissions & loads, mutual fund expense ratios, and trading costs. In that post, we saw that these expenses could cut the size of your retirement portfolio in half! Frankly, I was surprised at the magnitude of the impact. How can shaving only one or two percentage points off your annual return have such a huge impact? Read on.

The Impact of an Additional 1% in Annual Return on Investment (ROI)

The above chart (click to expand) shows the yearly return from a hypothetical $1,000 investment in the stock market over a 40-year period -- e.g., an investment held from age 25 to 65. For each year, the dark blue section shows the return at 9% compounded annually. The solid brown section shows the return at 1% compounded annually (note: this is the virtually invisible section between the dark & light blue sections). Without looking at the graph, you might be tempted to guess that 10% compounded annually is the sum of the two; it's not.

The Magic of Compounding

Because of the magic of compounding, the actual returns at 10% are substantially more than the sum of the 9% and 1% returns. In addition to earning 9% on the portfolio you would have had if your investment was only earning 9%, the investor is also earning 9% on the additional monies attributable to the extra 1% (the textured blue section). And, in addition to earning 1% on the portfolio you would have had if your investment was only earning 1%, the investor is also earning 1% on the additional monies attributable to the extra 9% (the textured brown section). (See appendix for sample calculations) The top line of the graph is the sum of all four sections, and is the annual return at 10%.

As you can see from the chart, the difference between 9% and 10% returns increases with time. At age 65, this investor would be earning $2827/year on a 9% investment. At 10%, the age 65 earnings increase to $4526. The additional 1% annually adds $1700 to the year's income -- way more than the $15 that a $1,000 investment at 1% would earn by itself in its 40th year.

The Surest Way to Increase the Size of Your Retirement Portfolio

Just to be clear. Increasing your net annual return by one or two percent per year can have a huge impact on your stock and bond portfolios. Because bond returns are typically lower than stock market returns, a 1% increase will have an even greater impact on bonds than on stocks.

And, it doesn't matter how you do it. Decreasing your expense ratio by 1%/year will have the same impact as increasing your gross returns by 1%/year and keeping your expense ratio the same. The difference is it's a lot easier to figure out how to reduce your expense ratio by 1% than it is to figure out where to find an additional 1% in gross investment returns.

Appendix: Sample Detailed Computation

Year 1: 10% return is the same as 9% return + 1% return.
$1,000 x 10% = $100 (therefore, have ($1000 + $100=) $1100 to carry to year 2 at 10%)

$1,000 x 9% = $90
$1,000 x 1% = $10
$100 = $90 + $10

Year 2:
$1,100 x 10% = $110 (the 10% return in the 2nd year)

$1090 x 9% = $98.10 (what the 9% investment would earn separately in the 2nd year)
$1010 x 1% = $10.10 (what the 1% investment would earn separately)
$110 is greater than $98.10 + $10.10 by $1.80
The difference is that you will have $1100, not $1090, earning 9% in year 2; and, $1100, not $1010, earning 1% in year 2. Here's the contribution from the extra amounts.
$10 x 9% = $0.90
$90 x 1% = $0.90
for a total of $1.80